Bid fever heats retail as FTSE holds steady

While markets remained firm, volumes were weak. Just 2.6 billion shares were exhanged by the close of London deals, down by about a billion on recent days.

In the world of charts and chartism, reduced turnover is sometimes believed to indicate further weakness to come.

That theory tallied with opinions at Morgan Stanley, where the strategy team was arguing that stock valuations have now outstripped likely earnings growth. The Wall Street bank today moved equities back to “neutral” in its recommended European portfolio, advising clients to take profit on shares and keep hold of the cash.

“2006 will be the year when earnings revisions finally turn down after nearly two years of positive revisions,” said Morgan Stanley. It forecast corporate profit growth for Europe as a whole of just 4 per cent, versus the City consensus of more than 10 per cent.

The US bank’s team noted that more than three-quarters of European stocks are expected to improve profit margins this year, even though they were already making record margins in 2005. That provides plenty of room for disappointment, it said.

“We are not yet calling a peak in the market,” argued Morgan Stanley. “We are simply saying that in our view risks are rising that we have a defensive rotation while earnings catch up with stock market prices.”

Morgan Stanley’s concerns about stretched valuations have been voiced before. But recent takeover approaches throughout Europe have underlined that, when debt is cheap, earnings multiples may not matter so much when there is enough cash generation to repay the loans.

HMV today became the latest UK name to attract a predator: shares surged 27.75p to 192p after the music and books retailer admitted to receiving a preliminary approach from a suitor it did not name.

That followed the Sunday Times reporting interest in HMV from venture capital firm Permira. Merrill Lynch has been appointed to advise on a takeover offer that could be priced at £800 million or 200p per share, according to the paper. (Permira and Merrill would not comment.)

Evolution Securities noted: “The business model looked to have been very badly undermined at Christmas by aggressive competition from supermarkets and online retailers, but HMV still generates lots of cash, which is always attractive to private equity.”

The bid news lifted fellow high street retailers such as Woolworths (up 0.5p to 31p), Kesa Electricals (firmer by 5p to 251p) and WH Smith (ahead 12p to 400p). Credit Suisse sent round a note to its day-traders advising that all three stocks were short-term buys.

“The potential bid for HMV raises the prospect of other traditional bid spec stocks being bought to cover the possibility of a further wave of opportunistic VC buying in the sector,” it said.

Analysts at the Swiss broker were calling Woolworths up to 40p on the back of the HMV approach. It noted that, exactly a year ago, Apax Partners pitched an offer at 55p which the pick & mix retailer rejected. Two months later, Apax won support of Woolworths’ board by raising its indicative offer to 58.2p. But that deal broke down in April 2005 during the due diligence process and Apax turned its attention to supermarket Somerfield.

But Nick Bubb, Evolution’s retail guru, questioned whether Apax or anyone else would how be keen on chasing Woolworths. “Our view is that private equity has passed over Woolworths in favour of HMV, so a switch from Woolworths to HMV could well make sense,” he argued.

Ottakar’s underperformed the retail sector, finishing down 1.5p to 315p but recovering from a drop to as low as 285p.

HMV’s bid for the independent bookstore was referred to the Competition Commission last month, and there were doubts Permira would be keen on completing the deal even with the watchdog’s permission. That may not be the end of the story, however:

“If HMV are not going to bid, the field could be opened up for WH Smith to get Ottakars at an attractive price,” Mr Bubb said.

Read the Sunday Times story about HMV here.

Among the blue chip retailers, Next added 25p to £17.23. UBS raised its share-price target to £20 from £18.50, based solely on gains for the wider stock market. It said that, while trading risks remain, a trading statement at the start of January “reinforced the market’s understanding of Next’s defensive merits, competitive advantages and growth strategy”.

Track Next shares here.

Oil stocks provided another line of support for the FTSE 100 after Exxon’s forecast-beating numbers, and in advance of an OPEC meeting in Vienna. Oil priced rose for a third day to top $68 a barrel after Iran said it would be calling for a production cut at the tomorrow’s cartel meeting.

BP was ahead 16.5p to 682p and Shell took on 42p to £20.02. The two companies account for about 18 per cent of the FTSE 100’s value and have been instrumental in powering the benchmark towards four-year highs.

High oil prices over recent quarters mean Shell looks likely to announce a record profit on Thursday. (For a detailed preview of this week’s events, click here.)

However, ING argued that without industry consolidation or big new discoveries, further gains for the energy stocks are looking unlikely. “This is as good as it gets,” the broker said.

“The integrated majors still generate lots of cash, but the sector is unlikely to beat the broader equity market beyond (the second quarter) without significant new growth generators coming to the fore,” ING told clients. It downgraded ratings on BP and Shell to “hold” and “sell” respectively.

Track today’s trading by industry sector here.

In the mid-caps, healthcare software supplier Isoft warned of a shortfall in full-year revenues due to delays in the £6.2 billion modernisation of Britain’s National Health Service computer systems. The company had previously assured it would not be affected and the NHS cash was close to secure.

Delays to the project, which accounts for about a fifth of Isoft’s revenue, has created “uncertainty” for the financial year, the company said. Translated, that meant zero visibility on when sales will actually arrive, and led analysts to cut forecasts in half for each of the next three years.

“Until clarity emerges on the phasing of NHS revenue in the coming months the stock becomes difficult to meaningfully value,” said Deutsche Bank, which cut the stock off its “buy” list. Shares tumbled 160.75p to 200p.

For detailed information on Isoft, click here.

Further down the market, Filtronic dropped 76p to 168.5p after the communications hardware maker warned on profit and its chief executive walked.

Filtronic said second-half sales and profitability would be hit by delays to large wireless infrastructure contracts for US customers, as well as pricing pressure and increased development costs. Analysts reckoned demand had deteriorated from Ericsson, while Lucent caused the contract delay because of roll-out problems with mobile phone operators Cingular and Verizon.

John Roulston, Filtronic’s chief executive, resigned, leading to speculation about a boardroom fall-out. Analysts at Cazenove noted: “He came from a large defence company background which operated in a less dynamic environment than that in which Filtronic operates. He also never seemed wholy comfortable with the non-defence business.”

For detailed information on Filtronic, click here.

Sanctuary, the record label behind Morrissey and The Strokes, slid 0.27p to 0.78p after revealing a few details of its rescue refinancing, a move that will leave current shareholders out of pocket.

The company said it is close to raising £110 million through an equity issue and will be writing off debt of £35 million. That came against the backdrop of weak trading, with delayed and cancelled albums resulting in a full-year operating loss of £41.6 million (analysts had pencilled in about £12 million.)

Sanctuary’s net debt at the period end totalled £140 million, about 40 times its equity-market value. The key questions not answered by today’s statement related to how much of debt the restructured company will carry, and how badly damaged its reputation will be within the music industry.

“If the financial future of the company is rescued by the major refinancing, will this prove a pyrrhic victory if the company goes ex-growth,” commented Investec.

Track Sanctuary shares here.

Finally, Stagecoach was easier by 0.75p to 113p on concern about its franchise to run trains between the south west of England and London’s Waterloo Station. The group’s South West Trains unit has been operating the four-year contract since February 2003, and bidding on a new deal is due to start in autumn.

Morgan Stanley cut its rating on Stagecoach to “underweight” based on what it saw as a shift in the makeup of the rail market, which could allow one or two companies to dominate. That follows rival FirstGroup last year winning two key rail contracts.

The South West deal is estimated to account for about 40 per cent of Stagecoach’s operating earnings this fiscal year and 30 per cent next. Management will therefore be expected to pull out all the stops and protect its incumbent position. But Morgan Stanley argued that too much good news is already being priced in. On a worst-case scenario, it reckoned Stagecoach shares could be worth just 79p each.

Elsewhere on broker watch:

Hiscox moved to “neutral” from “buy” at UBS, which also upgraded Catlin to “buy” from “neutral”.

Merrill Lynch raised Barratt Developments to “buy” from “neutral” and made the opposite call on Bovis, Bellway and Taylor Woodrow.

Duetsche Bank restarted coverage of Old Mutual with a “buy” rating and 22p share-price target.

Credit Suisse moved to “neutral” from “outperform” on BSkyB and cut Hays to “underperform” from “neutral”.

WestLB cut Marks & Spencer to “reduce” from “hold”.

Seymour Pierce raised HMV to “hold” from “underperform” and dropped Isoft to “sell”.

Panmure Gordon went to “sell” from “buy” on Isoft.

Bridgewell went to “neutral” from “buy” on Isoft, and raised Hornby to “overweight” from “neutral”.

And Goldman Sachs raised BT Group’s American depository receipts to “in-line” from “underperform”.

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